Written by

Dr. Ira Kalish

Published

November 20, 2013

Awaiting reform

As this is being written, the third plenary meeting of the Chinese Communist Party is about to begin. In the past, major policy changes have come out of third plenary sessions, and it is expected that this meeting will be similar. Once we go to press, the meeting will have ended, and more will be known about what the leadership intends to do. The widespread expectation is that the leadership will focus on financial reform (possibly allowing deposit interest rates to move freely), fiscal reform (shifting the balance of spending and taxation between the central and regional governments), and deregulations that permit more competition in various industries. On the other hand, the leadership is not necessarily expected to take significant action to privatize state-run companies or banks. One area that the leaders have spoken about, but where reforms will be challenging, is residency permits and further rural-urban migration. However, it is not clear what exactly the leadership intends to do. In addition, China’s leadership has historically taken a gradualist approach to reform, so it is not expected that anything radical will be announced in the meeting.

Meanwhile, in a speech in October, Premier Li Keqiang stated that the economy requires growth of 7.2 percent in order to keep unemployment stable. He said this growth rate would allow an increase in employment each year of 10 million workers. He also said that the government is reluctant to utilize fiscal or monetary stimulus to boost growth. Referring to the credit-tightening episode in June, he said that the government did not panic, nor use stimulus to resolve the problem. Specifically, he said that such policies would have been like “trying to extinguish a fire with wood”—that is, they might create an even bigger fire.1 Meanwhile, China’s central bank said that, although inflation is not high (3.1 percent in September), there is a danger of higher inflation going forward. Thus policy must be vigilant. It said, “The foundation for stable consumer prices is not solid. Annual consumer inflation may rise in the fourth quarter.”2 In addition, rising house prices are a continuing concern for the central bank.

Thus it appears that the authorities are attempting to balance several competing influences. On the one hand, they are worried about inflation and a housing price bubble. On the other hand, they are concerned that more restrictive policies will slow growth too much. On the one hand, they want to keep the economy growing, even if it means perpetuating excessive debt-fueled investment. On the other hand, they want to focus on reforms that will enable more sustainable growth in the future—including growth not based on investment in fixed assets.

Meanwhile, China will be left with plenty of empty homes.

Banking and housing

China appears to be facing a housing bubble. House prices in China rose 9.1 percent in September. In China’s four major cities, prices jumped in September at the fastest pace since 2011. Prices were up 17 percent in Shanghai, 16 percent in Beijing, and 20 percent in both Shenzhen and Guangzhou. Moreover, prices were up in 69 of 70 major cities. The authorities are clearly torn between a desire to keep the economy growing and a desire to avoid a housing-related financial crisis.

The relatively strong economic growth of the third quarter was partly driven by construction, which itself was fueled by the rising prices of houses. It reasonably can be inferred that loans to property developers have been rising rapidly. There are two problems stemming from this excessive investment. First, it could lead to problems servicing the loans, thereby hurting banks and requiring government bailouts. When prices eventually fall, troubled mortgage holders will not be able to simply sell their properties in order to pay off their mortgages. Meanwhile, China will be left with plenty of empty homes. Second, the rising prices of homes are reducing the number of people who can afford to purchase homes. This in turn could lead to frustration on the part of lower- income households.

Where do Chinese banks stand? It has been reported that the top four banks in China experienced a 3.5 percent increase in the volume of nonperforming loans in the third quarter.3 This was the biggest increase since 2010. Although bank profits continue to rise, this cannot go on forever if the volume of bad debt continues to increase. Indeed, markets are already reacting by pushing down the equity prices of Chinese banks. The surge in bad debts is related to many factors, such as excess capacity in many industries, slowing economic growth, local government investments in poorly performing projects, and private investments in properties that have not been resold (including so-called “ghost towns” of unoccupied apartment complexes). The result of all this borrowing is that interest payments on debt have increased from 7 percent of GDP in 2008 to 12.5 percent today, according to rating agency Fitch. Moreover, Fitch expects this number to continue to rise, creating a potentially unsustainable situation.4 China’s leaders face a huge problem in dealing with the unwinding of this massively unbalanced economy.

Large Chinese banks have substantially increased the pace of write-offs of bad debts. This is likely being done in order to prepare for a fresh wave of defaults on loans. Also, regulators lately have eased rules regarding write-offs. Interestingly, bank profitability has not yet been hurt because the banks had already set aside large loan-loss reserves. While they had been told to set aside 150 percent of bad debts as reserves against losses, they have actually gone beyond this, setting aside 272 percent. The authorities continue to encourage these reserves. However, the authorities have also told the banks to set aside 2.5 percent of all loans—a goal that has not yet been reached. Given the huge increase in debt in the past few years, and given that much of it was used to finance loss-making projects, there is a widespread expectation that defaults are going to increase substantially, and soon.